Bond yields, Rupee to see higher impact due to Budget than markets

The past few months have seen massive volatility in the global foreign exchange market. The dollar is up, the yen has crashed and most other currencies have lost ground versus the dollar. Several factors have been at play.

In terms of geopolitics, there was a shock result to the US elections. The dollar strengthened and the Federal Reserve’s decision to hike the policy rate in December pushed it up further. US bond market yields have shot up. It’s forecast that US inflation will rise. President-elect Donald Trump’s protectionist policies could mean more US manufacturing. Employment is tight and wages are far higher than in Mexico and China.

In addition, there has been a global commodity revival. Metals and crude oil have firmed up to some extent. This has meant higher inflation in Europe as well. On average, the euro zone is now seeing inflation at three-year highs. However, the European Central Bank continues to maintain a negative policy rate; it has committed itself to a Quantitative Easing (QE) programme till December 2017. 

Japan is in an interesting spot. It also has a negative policy rate and an enormous QE. For the first time in years, Japanese businesses are expressing some confidence in economic recovery. The yen has fallen; inflation is edging into positive territory. Exporters hope for a boost. Sterling is also down versus the dollar and, even as the UK braces for Brexit, it hopes a weak pound will boost the economy.

China has seen the yuan drop, though it is not a free-float currency. The People’s Bank of China has burnt $1.2 trillion in reserves to shore up the yuan. China has also seen inflation rising, with the equivalent of the wholesale price index moving to 5.5 per cent year-on-year in December. That’s due to higher commodity prices. Retail inflation is reasonably low at two per cent. The Chinese bond market has seen massive volatility due to fraud and sell-offs. But, growth has been reasonably strong.

In the midst of this, India has suffered demonetisation. We don’t have clear data about the full impact of that shock. Inflation is down, temporarily at least. Growth has taken a hit, by available data. 

The rupee has seen severe gyrations. It hit an all-time low of 68.7 to the dollar in late November and has traded below 68 many times since. It is down over two per cent versus the dollar since November 1. And, down about 1.4 per cent versus the pound in the same period, up by 1.4 per cent versus the euro and by a whopping 7.5 per cent versus the yen. The rupee has gained very marginally versus the yuan since November.

The rupee has seen selling pressure due to several reasons. Foreign portfolio investors (FPIs) have sold both rupee debt and rupee equity in large quantities in the December quarter. The Reserve Bank of India (RBI) had to complete a reverse swap of about $26 billion equivalent. Rising crude oil prices are a third reason for the rupee to have lost ground. The fourth reason is that the difference in yields is narrowing between the rupee (bonds yields are falling) and the dollar (yields rising from near-zero). This reduces the attractiveness of rupee assets.

Of these variables, only the RBI swap is out of the equation. FPIs remain negative on emerging markets. Crude oil still looks strong; the dollar looks strong. Another burst of volatility can be expected over January 20-February 1 as Trump is sworn in, and the Budget is announced. Most traders expect the rupee to slide some more. But, there could be sudden rupee spikes on short-covering as well. More than the stock market, the Budget could impact bond yields and currency rates.